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Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
ENGINEERING ECONOMY Fifth Edition Mc

Blank and Tarquin Graw
Hill
CHAPTER 16
DEPRECIATION METHODS
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University 1
16 Preliminary Statement
The material presented in this chapter

applies to the current (2001) U.S.
Federal Corporate Income Tax Code
relating to depreciation.
As such, which changing legislation,
parts of this chapter could be modified
by legislation enacted after publication
of this text.

Hill
CHAPTER 16
Learning Objectives
16 Learning Objectives
1. Depreciation Terminology
2. Straight-Line Depreciation
3. Double Declining Balance
Depreciation
4. Modified Accelerated Cost Recovery
System (MACRS)
5. Determining the MACRS Recovery
Period

Hill
CHAPTER 16
16.1
DEPRECIATION TERMINOLOGY
16.1 Depreciation – Definition
Depreciation is the reduction of an

asset’s value over time.
Brought on by:
 Wear and tear, use;
 Deterioration;
 Obsolescence.
Other definitions follow:
16.1 Depreciation–Definition
Depreciation – Original Reason:

 Purely economic!
Economic View:
 Depreciation represents a “ratable” using up
of devaluation of a productive asset.
 The asset must have a finite life span that
can be reasonably estimated.
 Deprecation represents a proper charge
against future income produced by the asset
in question.
16.1 Depreciation and Depletion
Depreciation provides for the

retirement of a productive asset;
Depletion provides for the use of a
natural resource;
Amortization recognizes a prepaid
expense for tax purposes.
16.1 Importance of Depreciation
Federal tax law defines the concept of

“taxable income” as:
 Gross Income – Real Cash Expenses –
interest – Depreciation amounts.
Tax Due =
 {Taxable Income}(Tax Rate).
Taxes and after-tax cash flows are
presented in Chapter 17.
16.1 Tax Deductions
Federal Tax law permits the reduction

of Gross Income by a category of
elements termed “deductions”.
Most “deductions” are real cash flows:
 Wages and salaries;
 Cost of materials;
 Utilities;
 Interest Paid on debt;
 State and local taxes paid;
 Etc.
16.1 Tax Equation
The General Federal Tax Equation Is:

Tax. Income = Gross Income – {Real
Expenses + Interest Paid + Depreciation +
Depletion}
All of the above amounts EXCEPT

depreciation amounts and depletion amounts
are real cash flow to the firm.
16.1 Non-Cash Flow Amounts
Depreciation and depletion amounts

represent “non-cash flow” amounts
within an accounting period.
Federal and state tax laws recognize
various forms of depreciation amounts
and depletions amounts to be “tax-
deductible amounts,” but are not real
cash flows per se.
16.1 After-Tax Cash Flows
All “for profit” firms seek to minimize

legally their respective income tax
liabilities.
Depreciation and depletions amounts
will lower the taxable income amount
and hence the tax liability if claimed.
This chapter focuses on the various
forms of depreciation and depletion
calculations.
16.1 Depreciation Amounts
Federal tax law states that:

 Any productive asset with a finite life
(greater than one year) must be depreciated
for tax purposes rather than “expensed” in
the year of purchase.
Depreciation amounts represent a
prorated amount per year that can be
treated as an “expense” (deduction),
but is not a real cash flow.
16.1 Tax Savings from Depreciation
Depreciation amounts represent a form

of tax savings to the profitable firm.
Assume a tax rate of, say, 30%.
For every $1 of eligible deductions the
resultant tax savings is:
 (0.30)($1.00) = $0.30.
 $1 of additional deductions saves the firm
$0.30.
16.1 Simple Example
Consider a basic sewing machine that is

used to sew shoes;
Assume this sewing machine sews
300,000 pairs of shoes, pair by pair.
The sewing machine is losing value
over time due to the use of the machine.
An Economic Concept is at play….
16.1 Simple Example
If the sewing machine costs $2,500 to

begin with, then;
The initial cost of the sewing machine
should be prorated over the 300,000
pairs of shoes.
The initial cost of the sewing machine
is termed the BASIS of the asset.
One can allocate the original basis over
the number of pairs of shoes the
machine produces.
16.1 Types of Depreciation
Book Depreciation
 Used by a firm for internal financial and
managerial management.
Tax Depreciation
 Used by a firm for state and federal income
tax reporting.
 Follows strict rules and regulations.
16.1 Book Depreciation
Value of the asset on the firm’s

accounting records at any given point in
time.
Used for internal managerial decision
making.
Management is free to use any method
they so choose to compute book
depreciation amounts.
16.1 Book Depreciation
Used internally by the firm;

Be any method:
 Straight Line,
 Declining Balance;
 Sum-of-the-years digits;
 Other.
Defines the reduced investment in an
asset based upon usage pattern and an
assumed life.
16.1 Tax Depreciation
Tax Depreciation:
 Must follow current state and federal law
pertaining to acceptable methods for
computing depreciation for income tax
purposes.
Federal Lever (2001)
 MACRS Methods
 General Depreciation System (GDS).
 Alternate Depreciation System (ADS).
16.1 Book Value of an Asset
Book value:
 Accounting Term,
 Reflects the undepreciated (value) on the
firm’s books at a given point in time.
 May or may not reflect the true market
value of the asset at a point in time.
 Market value of an asset is what a willing
buyer and willing seller agree to
consummate a sale or exchange.

Hill
CHAPTER 16
DEPRECIATION TERMINOLOGY
Important Terms and Their Meanings
16.1 Terminology
The following slides state and define

depreciation terminology;
Terminology is very important to the
understanding of this chapter;
Please focus on the terms and their
respective meanings.
16.1 BASIS of an Asset (B)

The Basis of an asset is:
 Purchase cost plus,
 Delivery costs plus,
 Installation costs and,
 Any other costs associated with installing
and preparing the asset for use.
 To be eligible for depreciation, the asset
MUST be placed in-service and ready for
use.
 Symbol: B for “Basis” – a dollar amount.
16.1 Book Value of an Asset (BVt)
The remaining, undepreciated capital

investment on the firm’s books after the
accumulated amounts of depreciation have
been subtracted from the original cost
basis.
BV’s are usually updated at the end of the
firm’s accounting year.
16.1 Recovery Period - n

Recovery Period (in years) is the
depreciable life n of the asset in years.
Often there are different n values for
book and tax depreciation.
Both of these values may be different
from the asset's estimated productive
life.
Also known as the Depreciable Life.
16.1 Market Value (MVt)
Market value, a term also used in

replacement analysis, is the estimated
amount realizable if the asset were sold
on the open market.
Because of the structure of
depreciation laws, the book value and
market value may substantially differ.
16.1 Market Value (MVt)
For example, a commercial building

tends to increase in market value, but
the book value will decrease as
depreciation charges are taken.
A computer workstation may have a
market value much lower than its book
value due to rapidly changing
technology.
16.1 Salvage Value – S
Salvage value is the estimated trade-in

or market value at the end of the asset's
useful life.
The salvage value, S, expressed as an
estimated dollar amount or as a
percentage of the first cost, may be
positive, zero, or negative due to
dismantling and carry-away costs.
16.1 Salvage Value – S
Salvage values are estimated “up-

front” – at the time of the original
purchase.
As an estimated value, the actual
salvage value out at time t = n may or
may not reflect the original estimate.
Generally speaking, one cannot
depreciate an asset below its estimated
salvage value.
16.1 Depreciation Rate – dt

Depreciation rate or recovery rate is
the fraction of the first cost removed by
depreciation each year.
This rate, denoted by dt, may be the
same each year, which is called the
straight-line rate, or different for each
year of the recovery period.
16.1 Personal Property
Personal property, one of the two types

of property for which depreciation is
allowed, is the income-producing,
tangible possessions of a corporation
used to conduct business.
Not to be confused with an individual’s
personal property like clothes, furniture,
etc.
16.1 Personal Property – continued
Included are:
 most manufacturing and service industry
property vehicles,
 manufacturing equipment, materials
handling devices, computers, and
networking equipment,
 telephone equipment office furniture,
refining process equipment, and much
more.
16.1 Real property
Real property includes:

 real estate and all improvements
 office buildings,
 manufacturing structures,
 test facilities,
 warehouses,
 apartments, and other structures.
16.1 Real Property
Real property includes real estate and

all improvements – office buildings
manufacturing structures, test facilities,
warehouses, apartments, and other
structures.
Land itself is considered real property,
but it is not depreciable because it has
an infinite life – land can never be
depreciated for tax purposes.
16.1 The Half-Year Convention
During a tax year, assets are purchased

and installed throughout the first year.
Under past laws, the first year of
depreciation had to be prorated by the
number of months remaining in the tax
year.
Under current federal tax law the first
year is handled using the half-year
convention.
16.1 The Half-Year Convention
The half-year convention assumes that

assets are placed in service or disposed
of in midyear, regardless of when these
events actually occur during the year.
This convention is utilized in this text
and in most U.S.-approved tax-
depreciation methods.
There are also mid-quarter and mid-
month conventions.
16.1 Property Eligible for Depreciation
Real or personal;
 Productive assets;
 Buildings and structures, but not land.
Used in the pursuit of income
generation;
Have a finite, estimatable life
16.1 Depreciation Models
Basic (traditional) models are:

 Straight-Line Method (SL),
 Sum-of-the-Years Digits Method (SYD),
 Declining Balance Method (DB).
 Today, the MACRS Method (a form of
declining balance-modified).
16.1 Classical Methods
Classical Methods (supporting Excel

functions) are:
 Straight-line,
 SYD;
 DB.
16.1 History
Before 1981 – U.S. code recognized the

classical methods.
1981 and after:
 Classical methods were disallowed for
federal tax purposes and replaced with a
system termed ACRS – Accelerated Capital
Recovery System
 In 1986 ACRS was replaced with MACRS –
Modified Accelerated Capital Recovery
System.
16.1 Comparison of Methods
It is beneficial to compare:
 Straight-line,
 SYD, and
 DB methods.
The best way is to plot the book values
of each method vs. the recovery period
(time).
See Figure 16.1 on page 510.
16.1 Book Value vs. Time: General Case
In general, a book value plot will look

like:
16.1 Book Value Plot for Classical Methods
For SL, DB, and MACRS we have:
16.1 Accelerate Depreciation
From Figure 16-1 on page 510:

 SL book values decline in a linear fashion
down to a specified salvage value.
 The DB method allows the book value to
accelerate faster since the DB plot of book
value is below the SL book values.
 MACRS also permits accelerated book
values, but is not as good as the pure DB
method permits.
16.1 Accelerating Depreciation
The SL methods writes off the asset in

equal amounts over the recovery period.
The DB method permits greater
depreciation amounts in the early years,
and hence reduces the book value faster
than the SL method.
Likewise for the MACRS method!
16.1 Accelerating Depreciation
More depreciation in the early years

means more tax savings sooner.
Assumes a profitable firm.
Tax savings early in the life of an asset
has a greater present value that tax
savings out in time.
Larger depreciation amounts early on
result in increased PW of future tax
savings to the firm.
16.1 What Does It Mean?
If the firm is profitable, then more

depreciation amounts in the early years
means:
 Lower tax liability;
 Pay less taxes – more $$ available for
reinvestment!
 The firm can retain more after-tax funds if
the depreciation is accelerated in the early
years of an assets’ life.
 Thus, more depreciation $$ early on are
better!
16.1 Keeping Up
All engineers engaged in the analysis of

industrial projects need to be
reasonably informed regarding the
current Federal Tax law regarding
depreciation.
The law does change!
Must keep up with the changes!
IRS Web site: www.irs.gov
 Check it out for downloadable publications

Hill
CHAPTER 16
16.2
STRAIGHT-LINE (SL)
DEPRECIATION
16.2 Straight-Line: The Standard (SL)
SL depreciation is the standard from

which all other plans are compared.
Assumes the book value declines in a
uniform manner down to a specified
salvage value – S over n time periods.
Assume n years for an asset’s life:
 The depreciation rate –dt is then:
Dt = 1/n
16.2 SL Example
Notation (to be followed herein)

 t = the year (t = 1,2, …, n)
 Dt = Annual depreciation charge,
 B = The first cost or unadjusted basis,
 S = Estimated Salvage Value at t = n,
 n = The Recovery Period,
 d = The Depreciation Rate = 1/n
16.2 Straight-Line Method
Compute the Basis minus the estimated

salvage value and divide by n
Dt  ( B  S )d [16.1]
BS
Dt  [16.2]
n
16.2 SL Excel Function
In Excel the built-in function is:
SLN(B,S,n)
Displays the annual depreciation Dt as a

single cell operation.
16.2 SL Example
B = $50,000;
“n” = 5 years;
S = $10,000 at t = 5;
Dt for each year is:
 ($50,000 - $10,000)/5 = $8,000/year
16.2 SL Example: Tabulation
t Dt BVt
1 $8,000 $42,000
2 8,000 34,000
3 8,000 26,000
4 8,000 18,000
5 8,000 10,000
16.2 Plot of the Straight-Line Book Value
16.2 SL Observations
The SL method starts at B and directly

targets “S” n time periods from the
present.
The Depreciation amounts are all equal
($8,000 in this case).
The book values decline at the same
rate down to $10,000.

Hill
CHAPTER 16
16.3
DECLINING BALANCE AND DOUBLE
DECLINING BALANCE
DEPRECIATION
16.3 Declining Balance Method (DB)
DB is an accelerated depreciation
method;
Provides greater depreciation amounts
in the early time periods over the SL
method.
Is more complex that the SL method.
Requires assuming a DB rate –
normally taken to equal 2 x SL rate.
16.3 DB Rate
Given the DB rate,

 Dt for year t is found by multiplying the
beginning of time period book value by the
rate.
The maximum DB rate set by law is:
 dMAX = 2(1/n), or twice what the straight rate
would be.
16.3 DB Equations Depr. For year “t”
Dt  (d ) BVt 1 [16.5]
t 1
dt  (d ) B(1  d ) [16.6]
Depr. Rate
16.3 DB if BVt-1 Not Known

If BV at the end of the preceding year is
not known, then apply:
t 1
Dt  (d ) B(1  d ) [16.7]
16.3 DB: Book Value Determination
BVt can be determined in two ways:

 1. Using the rate d and the basis, B or,
 2. Subtracting the current year’s
depreciation from the previous year’s book
value.
BVt from d and B:
 Apply:
BVt  B(1  d ) t
[16.8]
BVt  BVt 1  D [16.9]
16.3 DB: Implied Salvage Value
Note: From equations 16.4 – 16.9 there

is no mention of the salvage value – S!
DB does not directly use the estimated
salvage value.
DB has its own implied salvage value.
The pure DB method will never
depreciate an asset down to a 0 salvage
value unless you solve for a d rate
( Eq. 16.11).
16.3 DB: Implied Salvage Value
The implied salvage value built into the

DB method is:
S  BVn  B(1  d ) n
[16.9]
16.3 Implied SV for DB Depreciation
Permissible range for d is:

0 < d < (2/n)
To force a prescribed salvage value – S
apply:
 Implied d = 1 – (S/B) [16.11]
1/n
16.3 DB rate – d
By law, the maximum rate for DB is

specified to =:
 Twice the SL rate for a given n.
 This is called “The Double Declining Balance
Rate.”
 If d = 1.5 (SL rate), it is termed the 150%
DB rate.
 d can never exceed 2(1/n), but can be less!
16.3 Excel DB Functions
Excel supports the DB approach as a

single cell function:
Use:
 DDB(B,S,n,t,d) as a cell function.
 “d” argument can be omitted: If so, a “d” of

2 is assumed by Excel.
Excel also supports a “DB” function.
 Suggest one avoid using this one as special
care must be taken! DB(B,S,n,t)
16.3 Example 16.3
B = $80,000;
n = 10 years;
S = $10,000;
Apply the DB and DDB methods to
compute the depreciation amounts and
associated BV’s.
16.3 Example 16.3 DB approach
The DB method first computes the

implied salvage value from:
 d = 1 – (10,000/80,000)1/10 = 0.1877
 d = 18.77% will target the $10,000 SV at
t = 10.
See Table 16-1 on page 515.
16.3 Spreadsheet Model for Ex. 16.3

Hill
CHAPTER 16
End of Slide Set

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Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

ENGINEERING ECONOMY Fifth Edition Mc

The material presented in this chapter

ENGINEERING ECONOMY Fifth Edition Mc

ENGINEERING ECONOMY Fifth Edition Mc

16.1 Depreciation – Definition

Depreciation is the reduction of an

Depreciation – Original Reason:

16.1 Depreciation and Depletion

Depreciation provides for the

16.1 Importance of Depreciation

Federal tax law defines the concept of

16.1 Tax Deductions

Federal Tax law permits the reduction

16.1 Tax Equation

The General Federal Tax Equation Is:

All of the above amounts EXCEPT

16.1 Non-Cash Flow Amounts

Depreciation and depletion amounts

16.1 After-Tax Cash Flows

All “for profit” firms seek to minimize

16.1 Depreciation Amounts

Federal tax law states that:

16.1 Tax Savings from Depreciation

Depreciation amounts represent a form

16.1 Simple Example

Consider a basic sewing machine that is

16.1 Simple Example

If the sewing machine costs $2,500 to

16.1 Types of Depreciation

16.1 Book Depreciation

Value of the asset on the firm’s

16.1 Book Depreciation

Used internally by the firm;

16.1 Tax Depreciation

16.1 Book Value of an Asset

ENGINEERING ECONOMY Fifth Edition Mc

The following slides state and define

16.1 BASIS of an Asset (B)

16.1 Book Value of an Asset (BVt)

The remaining, undepreciated capital

16.1 Recovery Period - n

16.1 Market Value (MVt)

Market value, a term also used in

16.1 Market Value (MVt)

For example, a commercial building

16.1 Salvage Value – S

Salvage value is the estimated trade-in

16.1 Salvage Value – S

Salvage values are estimated “up-

16.1 Depreciation Rate – dt

16.1 Personal Property

Personal property, one of the two types

16.1 Personal Property – continued

16.1 Real property

Real property includes:

16.1 Real Property

Real property includes real estate and

16.1 The Half-Year Convention

During a tax year, assets are purchased

16.1 The Half-Year Convention

The half-year convention assumes that

16.1 Property Eligible for Depreciation